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Market Update: An Early Look at 2022

First Republic Investment Management
October 8, 2021

This timely discussion on market updates features Christopher J. Wolfe, Chief Investment Officer of First Republic Investment Management, and Mike Selfridge, Chief Banking Officer of First Republic Bank.

Read below for a full transcript of the conversation. 

Mike Selfridge - Well, good afternoon, everyone. My name is Mike Selfridge, I'm the Chief Banking Officer at First Republic Bank. And I just want to thank you for joining us for our quarterly markets updates. And I'm delighted as always to have joining me Christopher Wolfe. Christopher is our Chief Investment Officer at First Republic Investment Management, and he oversees the research and strategy for our $241 billion in assets under management. So without further ado, I'm going to get into a series of questions. And I should say, Chris, you may have seen him on a number of television interviews or in various publications. I consider him to be an influencer in the world of economics and money management. So I'm always delighted to be able to host these for our clients. So Christopher, welcome. Good to see you as always.

Chris Wolfe - Thank you.

Mike - I have a lot I want to ask you and for our clients on the line, if you have a question, please submit those in the Q&A and I will get to those throughout this webinar. But Christopher, we have on at least my list, we have the economy, we have inflation, supply chain, commodities, crypto, liquidity, and equities and rates. So I'm going to try to get to all of that.

Chris - Just a few things.

Mike - I hope in an hour, but let's maybe recap since we did this in July. I think there was a little more optimism in July that got a bit quashed by the Delta variant. And at least from what I see, and maybe what your thoughts are from the high level of the gross domestic product feels like maybe things have slowed down a little bit from a bit more of the euphoria we had back in July. So I'd love to get your thoughts. I think we're talking about a seven handle on GDP for the year. How is that playing out as we close 2021?

Chris - Well, I think the simple reality is we were just a little bit too bullish back then. Our expectations were that the two bridges we talked about, the healthcare bridge and the stimulus bridge would work in tandem. They were up until the summer and the Delta variant took hold much faster than what we had anticipated. And the vaccine deployment has been much slower than we would have anticipated. Not that we had very fast timelines for the vaccine deployment, but it's just become a much more of a slog around the vaccine deployment. And that's really put, I think, two limiters on the growth story, at least for the remainder of this year. There's a bright side in 2022 potentially. But what that's done is it's lowered our expectations for overall growth with the economy down into the six handle range. So we're taking almost a hundred basis points out. And it's also meant that the profit story for the United States is likely to be a little bit lower in 2021, but maybe a little bit better in 2022. And that's really because we see some of those trends that weren't really fulfilled in 2021, actually lingering into 2022. And we'll talk a little bit about that.

Mike - Good. The theme for this year I think we can put a bow around it. You mentioned the two bridges theme for this year that you put out about a year ago. And so that was the stimulus, lots of stimulus still in the hands, coffers of the banks and consumers, but also the healthcare bridge. Have you put any thought into 2022 and any general themes? I know it's very early to ask that question, but would love your perspective. To me, a six handle GDP is not all that bad by the way.

Chris - No, for the remainder. Yeah-

Mike - Going into next year.

Chris - For the remainder of 2021. That's not bad. That's, you know, you can think about it this way. We were hitting the peak and economic growth in 2021. Things are gonna slow next year. If I had to kind of buttonhole it, we'll have a more formal document out later this year, but I would say 2022 is likely to be something along the lines of more inflation, less growth and less fed. Something like that. A little bit of this, a little bit of that is really what 2022 should shape up as, and what that's going to create out of that expectations of more inflation and less fed is likely to be some popcorn-type events in markets where we see different things going off at different times. And we can talk a little bit about that, but those are some of the interesting elements of what we think 2022 is going to shape up as.

Mike - So let's get into volatility and choppy waters. It feels like it's been a pretty bouncy ride for the last few months. Rates have risen back in the early part of the year, mainly on optimism of economic growth and recovery. Now rates are rising because the Fed's talking about tapering, tapering its spawn purchases today. The markets are up. Why? Because Vladimir Putin decided to provide some oil to parts of Europe to help ease some of the pain going on there. And of course this debt ceiling issue seems to be resolved. So we have Senator Mitch McConnell and Vladimir Putin seeming to help the market today just, and on the debt ceiling, maybe I could get your perspective. There's so much noise around this, which appears to again, be a kick the can down to December. But as far as I know, we've addressed raising, extending or revising the debt ceiling 78 times since 1960. Why is this so unusual? Is this just political jockeying going on or is there something bigger at stake here as it relates to the economy?

Chris - So without overplaying it, I think there's three points that we should talk about. The first is ultimately debt ends up being a political question, as much as anything. The idea right now with interest rates very low is that we can finance the debt interest payments as a percent of the overall budget are relatively modest at this point. And as long as rates don't rise a lot, we're not going to see that get in the way of other political decisions. At least for the near term. We worry about that a lot, particularly if there's more rate volatility, but right now everything is in an okay place. That's number one. Number two is the political story that we're seeing right now actually may have a different ending that is similar to what we saw in 2018 when we saw the government shut down. And that was a slightly different set of causes, but we got to a similar effect where the market said, whoa, this is not how we should be running things because now that we've kicked the debt ceiling discussions in November, we also have to talk about a government funding resolution in November and December. Sorry. So it's not clear to me that Senator McConnell isn't actually playing a longer game and trying to force more of an issue towards the year end. So the reality though, is that markets are going to interpret this. And I think very soon, look for analogies. And I think our second point is pretty clear. They're going to center on 2018 to say, gosh, what's likely to happen around that. So some of the relief we're seeing now in markets caused by the political challenges that we're seeing, I think may be short-lived. And it's, we want to be careful with respect to overall positioning in terms of equity markets going into the end of the year. And we'll talk a little bit about that later, but a lot of it's going to come down to rebalance, manage the profits and take them because we're likely to see a bigger piece of this discussion, which is my third point is where are we going to see reconciliation relative to other resolution modes? And that's going to be important because resolving things through reconciliation might have a couple of other effects related to see the filibuster and the way that we're going into the 2022 elections. So from our perspective, things are likely to get a little bit more bumpy as the year progresses because there's another deadline now. Kicking the can down the road just means that the decision's going to be a bit bigger and a bit more difficult as we get into December.

Mike - I think, I'll reiterate, I think two important points. One is paying our bills. That's one issue. The other is the budget and debts and deficits, totally separate issue. The consequences of not paying our bills. It would be devastating, wouldn't it?

Chris - Will be terrible. The last time we had to go around like this, which was solved four days later, it was in 2011 when we ended up with a debt downgrade or ratings downgrade in the US. So I think the reality though, is that there is an understanding for many in Washington that even though October 18 was listed by Janet Yellen as the treasury secretary, Janet Yellen, as the deadline, the reality is if you're looking at the way the inflows of money from tax receipts, et cetera, come into the state government and outflows, some of those things can be managed just like maybe a household might manage their balances. So that October 18 is a way to put a line in the sand, but there's probably a little bit of flexibility around that. The brutal reality though, is that that's now off the table because it's all going to December.

Mike - And I'm guessing this is also just the beginning of a little more posturing going on the latest stimulus. Are your forecasts based on some of the stimulus packages being proposed right now, namely the a three and a half trillion dollars?

Chris - Well, we've actually lowered them. And that's part of the lower growth trajectory for 2022 and beyond. Although we expect a little bit more in 2022 than in '23. So we might be kind of three and a half, maybe as much as 4% in 2022, in terms of GDP numbers and the issue there is that a lot of the stimulus programs that may remain in a paired down a bill, so not three and a half trillion, but maybe closer to and a half to two, more towards the two number end up having a longer tail to them. They last say seven to 10 years and only bits and pieces of it get deployed year after year. So the stimulus effect next year is likely to be actually a big negative. There's so much going in this year and not as much going in next year that a lot of people are going to wring their hands and go, "Oh, my gosh, all the stimulus has gone." And the answer is, "Yeah, we used it this year and it's in people's savings. And it's in other parts of the economy and we're going to have a little bit more going forward." So this handoff from stimulus to consumers and business spending is really what needs to happen to keep growth moving along in 2022. That's really the story. And that hinges on jobs, it hinges on inflation and it hinges on a number of other things like supply chain dynamics.

Mike - So great segue. I wanted to ask you about supply chain and then we'll get into inflation, which seems to be on everybody's mind. Supply chain, secretary of transportation, Pete Buttigieg came out this morning. Pretty much said we're going to have a challenge with Christmas presents. In some cases, it could take years to resolve some of the supply chain issues. I don't know to what he was referring. But right now, obviously there's a lot of kinks in the supply chain and what you've referred to as the bullwhip effect of what's going on. How does this impact the economy and maybe just set the stage for what's going on and how severe is this supply chain issue that we're experiencing?

Chris - Well in the summer, we had talked about this being more of a technology issue. And that was where the bullwhip effect came from is if you kind of choke off one part of the supply chain at the very beginning of it, it can have bigger effects down the line. The reality is what we're observing is through a combination of factors and it's actually become very complex, almost everything has having challenges. And really you can kind of point to two elements of human behavior that are both present and future-oriented if you're thinking about where we are today now. One is hoarding. So when people have fear that they're going to run out of things, or they don't see what's going on, you start to see hoarding. If you've been to a Costco or a other kind of a Sam's Club or a wholesale club whatever recently you might see that there's rationing of things like toilet paper. So that has a lot to do with hoarding. "Oh, my gosh, right now I need to have some." But then there's a secondary effect, which is more for purchasers and managers of companies, which is, "I need to hoard, not just now, but for the future. I should order a bunch and make sure I stack up and get a priority for the goods I'm going to need when things actually get a little bit better." So that's creating a lot of demand that's relatively high in the system. That's likely to abate next year, but it's also choking the system up. Add to that, you have shortages in different areas in terms of port loading and unloading. You've probably noticed that there are many ships in San Pedro Harbor off Los Angeles. They are the same in New York, same in Savannah, same in Washington, they're all over the place. Ships are waiting to be unloaded, and it's not because there's not just enough workers. There's also rail car issues and loading and unloading. And finally, for those of you that are close watchers of you know, freight lines and other types of ocean shipping websites, you know, that the gap between what it costs to get a container from the US port of Los Angeles to Shanghai versus what it costs to go the other way is something like eight times, 200 bucks to go one way, 20,000 to go the other way. So what's important about that is it's creating some weird arbitragers throughout the entirety of the system, particularly because the United States import so much. I'll add one more piece around this, because this all ties back to a simple view, which is inflation is probably going to stay higher for longer. And there's a risk around that they're released to taper and the fed action.

The last piece of the puzzle, at least around the shipping is that this isn't just a short-term issue that we've just mentioned. There's a longer-term issue. The US has in many cases through a combination of offshoring, by the way, it wasn't just labor. It was manufacturing, it was off showing everything, run out of the capacity or not built sufficient capacity to make shipping containers, make chips. The foundry capacity in the United States is very low relative to where it was historically. So as we bought short everything that actually puts supply chains out into the global network, it meant that they were in some cases longer, but very efficient. And in some cases fast because of the way that we were moving things around the world. In the future for a bunch of reasons, tied to the way the United States relationship is with China, our view is that supply chains are going to get shorter, safer, but importantly, more expensive. That's an inflation story starting at the producer level that we think is going to pass through. I'll close with this point, because you mentioned it earlier. I didn't touch on it, which is the taper and the idea that the fed may need to move. One of the bigger risks, I think at this point is that the fed, which they've already indicated around their taper, I think it's mostly priced in at this point is they may have to act sooner. There is a real belief, as least as we observe it, that these inflationary pressures that we're seeing now, at least as the fed describes them are likely to be transitory. The challenge is that transitory doesn't have a defined date. Is it June of next year. Is it September? Is it December? Is it 2023? Our view is that these pressures that we've just been discussing now are going to last for awhile. And the risk there is it causes the fed to start changing their dialogue, or maybe even act sooner than they would have anticipated. Right now they've been talking about 2023, but sooner could mean somewhere in 2022, like the middle of '22.

Mike - So before I get to inflation, did you say $20,000 to get a container from China to here?

Chris - Yes. So from Shanghai to Los Angeles.

Mike - So should we be in the container investment business?

Chris - One of the best performing assets here to date is shipping containers.

Mike - Any idea how much they've gone up in price?

Chris - Several hundred percent. Sometimes those are 400% or more.

Mike - A lot better than some of the crypto, which we'll talk about. So inflation, I think your latest research is about to come out. It shows, so I think there are about 12 categories of inflation. The fed is, has I think still maintain this average of 2%. We're now pushing sort of a four handle on inflation and of the 12 categories I only counted three that were under 2%, nine, well over 2%, it doesn't seem to average out. And when you look at some of the areas like commodities and energy and new vehicles, these are serious double-digit inflation numbers. So how does that weigh into your thoughts on inflation and this transitory concept?

Chris - Well, I think that the simple answer is we think it's going to last longer than what is built into the system. And part of that is because it's what we're hearing from corporations. Corporations are starting to indicate that it's going to take us longer to resolve things. So for example, in the auto parts industry or auto industry, we thought a lot of things would start to resolve themselves by the time we got to the end of the year. And what we're hearing now is that it's going to be going in all the way into next year. Maybe even through a good portion of next year, we won't get back to say normal like you may have thought it would have been in 2019, for example, for a long period of time. Now that may cause some other things to happen, retooling, or maybe redirection in terms of what auto companies are doing, but it's not a simple problem in terms of using everything from chip sets to the inventory, et cetera, we've pulled things very tight in many of the supply chains. So tight that what we're observing is that the delay times in terms of orders and deliveries from some of the macro economic indicators are lengthening. And in fact, more and more survey participants in what is called the PMI Survey are indicating that it's taking longer and longer to get the things they need to make their products in order to get that down to consumer. So this story of inflation now taking root and maybe being higher for longer is something that we are watching closely. I think on the good news side though is the following that the way the government measures inflation using something called PCE or CPI, the Consumer Price Index or the Consumer Expenditures Data, is it's measured in a way that accounts for things in a basket of goods that only consumers buy. So this gap between what producers are feeling and what consumers end up buying is likely to be distorted for a period of time. It's very hard for example, to push the consumer price index up a lot because it's heavily weighted towards homes and housing exposure. There's a big piece around healthcare. There's some piece around autos and energy. That's important because energy prices have stayed high, but without kind of a broad set of the consumers data staying very high, garment prices, et cetera, it's difficult to have CPI run it four or 5% for long periods of time. That's just the way the math works.

To make it simple, with an example, energy's up a lot. You're with crude now up in the 70 range in order to make the same contribution that energy has made to the high inflation, like it's added one percentage point or more, next year oil would have to go from $70 a barrel to $130. They'd have to double again. Now I'm not saying that's possible. We think that's a very low probability, but the way that inflation will accelerate, I think from this point forward is a very difficult path. It's much more likely to stabilize in fact, drift a bit lower from some of these year over year effects that we're seeing. And that energy example is just a very good way to illustrate it.

Mike - Chris, a couple of questions I'm going to weave in here from our clients, but we'll get into the consumer and then I want to talk about China. Consumer actually is still pretty strong. I don't know what the latest sentiment numbers are, but consumers are sitting on about maybe an excess of $2 trillion of excess savings that theoretically could be spent or pumped into the economy. Banks, bank deposits are up $3 trillion from where they historically were as as a ratio of total loans, about 17 and a half trillion. There is a lot of liquidity in the system, and that has a lot of implications also on investment strategies like alternatives. But maybe just start from the consumer that drives a good portion of the economy. How has the consumer feeling about you think sentiment then looking forward?

Chris - So it's a great question because a consumer sentiment does have a over time, a strong linkage to consumer spending. And broadly speaking the consumer sentiment data, as well as some of the small business sentiment data still remain relatively positive. So remember, we're in an environment, even though there's supplier deliveries, you know, economic growth is still continuing relatively strong. We saw a pickup in retail sales over the summer, for example, or expectations that even though there'll be challenges in Q4, we'll still see a good amount of spending. I think, you know, the reality here for consumer and business sentiment being relatively high, it's going to take a lot to knock them down, say months of supplier delivery problems, for example. But what's surprising is that the consumer sentiment remains relatively high, despite the very big gap between jobs available and jobs taken, for example. So there's a, I think maybe a little bit of risk as the year evolves. But that said our expectation is that it should remain relatively high, barring some massive change to the tax code, which increasingly looks less likely. There will be some changes we anticipate, but not a huge change in terms of the overall tax picture. The last point about the consumer sentiment data and your savings point in mind is to keep in mind that that savings data really just accrues to the top 25% of the income strata. The bottom 75% have really not participated to the same degree in terms of the savings, because most of that was done through market appreciation that the top 25 have. So the real trick here is to get that top 25 to think about how they're going to use that savings. What are they investing in? And historically a lot of that goes right back into market. So let's bring this full circle back to the taper being mostly priced in. And even though the fed is going to be buying another 600 billion of bonds, at least over the next year, that's what they've indicated, as you've highlighted there is a lot of capital still sloshing around in the system, both in public markets and in private markets. So a couple of trillion dollars there as well, that should continue to fund ideas, investments, at least over the intermediate term. So I think those looking at the feds withdrawing, "Oh, my gosh, the stock market's going to crash." It's a big time out. We don't predict the future. We don't pretend to know that exactly what's going to happen. We make reasonable estimates, but it would seem unreasonable to me that it fed leaves then stock market crash. That simplistic notion is something we want to push against and say, Hey, there's maybe an opportunity to rebalance your portfolio, but not an opportunity to exit things completely. Not with all that money on the sidelines.

Mike - You mentioned jobs before I get to rates in a couple of questions there. There's 10 million jobs available in the United States today. The unemployment claims came in favorable today. And I think that's driving a little bit of the boost in the market. Unemployment, I think is just a, you know, pushing down to 5%. Any thoughts on unemployment in general and the road to recovery?

Chris - Well, you know, the true measure of unemployment in our view includes underemployment and that number is actually much higher. And I think you raised the point here, that headline number on what's called the U-6, is likely to on the next labor markets report, you know, be in a five range. Unemployment, according to that measure is lower. But I think the challenge here is that not only is there a lot of jobs available, but the underemployment numbers suggest that we're still in double digit land of unplus under employment. And that's really the biggest challenge here. So from our perspective, you know, there are some illustrative examples. I'm going to pick on a certain state without naming it that has, you know, over 200,000 jobs available of which the vast majority of them, something like 95% of them pay less than $15 an hour. And in many cases, more than half pay less than $10 an hour. So to an extent, there's a little bit of a worker strike in terms of taking lower paying jobs, et cetera, it seems to be going on. The question is how long will that last? And I think the expectation most economists have is that eventually we'll start to see folks coming back into labor force, but I think it's going to change. And our view is that change means that the labor force is likely to change quite a bit. We could see, for example, a greater amount of single proprietorship companies, individuals starting their own thing, working from wherever they would like to work. And sometimes that's hard to track in all the labor force data. But the reality is that we've started to see the beginnings of that people going off and doing their own things. Because now with technology, you can live in Casper, Wyoming, and actually do your internet business, et cetera. So that change I think, is going to cause us to rethink how we're looking at just the simple numbers of unemployment equals five, therefore good. You really have to get into the details of what people are doing and look at business creation and use some of that analysis to make a better view on how you think consumption is likely to evolve because by the headline numbers, you'd worry that, "Oh, my gosh, there's all these jobs unfilled and businesses are going to falter," but businesses are responding by putting more robots and more technology in the place of people. You can walk into a McDonald's today and find a kiosk and a fewer people behind the counter. It's just a simple example of where you're seeing greater use of technology, combine that with where labor is moving, where they want to be. And we're having the dynamics for a much different labor force than we've had in the past. And I think that's probably a good thing, but it's going to be miscounted in the data. And I think that's one of the things that the fed is going to have to work through before they make big changes to their interest rate viewpoints.

Mike - You know, more than anyone, the fed has a dual mandate, right? Price stability, and sustainable full employment. So I'm sure they're watching it closely. I have a lot of questions on rates and your thoughts on the 10 year treasury, maybe I'll ask that more broadly because predicting the 10 year treasury is very difficult when it can't be controlled. But the fed can control short-term rates. So I think a former secretary of treasury, Mnuchin came out this morning. He said, he thinks we're going to get to a three and a half 10 year treasury. We're a little over 150 today. Now not that he's right or wrong, but we've got tapering in effect, maybe a recovery. Well, what are your thoughts on any fed action with regard to rate increases when, and then how that kind of plays out into things that drive interest rates from banks like the 10 year treasury for mortgages and credit cards.

Chris - So given the way the buying programs work for the fed right now, it seems realistic to us. We think the market is pricing this, and this is why I mentioned earlier. It's probably priced in the taper is that the buying program, the inverse of that is how the path of rates will evolve. So it's going to taper. And what that'll mean is that rates will move up a bit, a bit, or at least the path should follow the way the fed is tapering in terms of rates. And that probably towards the end, it gets a little bit more spiky, little bit more volatile. So by summer of next year, we'd expect to see more 10 year rate volatility. But what that path suggests is that we're headed to two, somewhere by the end of this year, number one. And number two, you could be headed to a two to three over the course of 2022, but I think a lot depends on how this inflation story and pricing pressures play out. How the US-China dynamic plays out because that whole shipping issue has some roots in China. And what that could mean is that we could get to the 3% faster, depending on how the fed acts. And I think at that point, the faster the fed acts, you have this other effect, the more likely they are to be perceived as being on top of the inflation story, and that will probably flatten the curve out. So I think folks looking for a runaway, 10-year going to five or six, that's a really tiny probability in our view. Again, never say never, but very tiny probability, much more likely that there's a gradient at least that we would expect around fed tapering and reduced purchases and that their risks really lie around whether or not the supply chain data that we're seeing stays in a difficult spot that pushes the fed to act sooner rather than later.

Mike - And fed actions, well, if inflation was persistent that could create fed actions, but likely in your view would it be more around a growing economy and a stronger recovery?

Chris - So the interesting thing is that, you know, if you take the Milton Freedman approach, you know, inflation is everywhere and always a monetary phenomenon. Most people get it wrong because they just assume money printing equals inflation. And what really ends up being is scarcity is the source of inflation. And that's a challenge we're thinking of seeing right now is there's just scarcity of a lot of different things. The raw materials, you know, auto manufacturers holding steel rolls, for example, there's just a lot of that going on in the system. And it takes a while to change their expectations and get them back to a place where there's confidence that the system won't see, either price jolts or supply jolts. Those two things tend to send humans into behavior patterns that create inflation. It's what economists called getting rooted. And it gets rooted when people just have to hoard. And they also hoard not just for the present, but for the future. And that's where you start to create this scarcity issues and how long those lasts depends a lot on how well the United States can resolve some of the challenges with China, how quickly we can get some of these arbitrage situations of shipping containers sorted out and some of the different ports and how much we can get some of these bottlenecks resolved. And by the way, it's not just shipping. It's trucking. We're short, according to the international trucking industry, 60 plus thousand, I think the number is 63,000 drivers. You have a lot of challenges moving things around this economy right now. And that's really the source of the inflation. And because it takes time to resolve them, time to unload boats at ports, time to train drivers. We're talking about at a minimum months of these kinds of conditions being with us.

Mike - Wow, that's interesting, Chris. You mentioned China. We have a couple of questions on China. Let me, if I can, I don't want to make it a political statement, but political tensions are high. China is conducting military maneuvers over Taiwan. The United States, Japan and the UK are countering with naval maneuvers. We're at bilateral ties are at a 50 year low. The Biden Administration has in so many words said they want to ensure that China does not become the world's leading economy. The numbers would suggest otherwise. China's been going for the last 10 years at nine and a half percent. We've sort of been 3%. And as of today, they are the second largest economy and growing and if the gap continues in the growth rate, they could be the largest economy within seven or eight years from now. And I remember hearing this 20 years ago when China was nowhere near the second largest economy. Having said that just from an economic perspective, we're their biggest client. We buy their goods. They're our biggest bank. They finance us. But also in the tech world, I'd love to get your views on the tech world. It seems like a tit for tat. So we have Amazon, they have Alibaba. We have Facebook, they have Tencent. We have Twitter, they have Sina. We have Apple, they have Xiaomi. What is going on in this bifurcated tech world. And then just the escalation of tensions and what that might mean for us from an economic perspective.

Chris - Well, I think in the simplest way, and this is over simplifying, but it's illustrative, it's IBM versus apple. You ended up in the technology world, starting in the 80s with two different standards. One was smaller and eventually grew to be more consumer-oriented. And one ended up being more business and service-oriented. Both companies still around. One has grown much stronger than the other. And that's illustrative to your point. This technology challenge of two different standards in two different markets is an interesting one because the US has long been a hotbed of innovation, but it's much, much less, the Western markets are much less cohesive. It's really United States, Europe and to some extent Africa and South America, that the broad market of Western technology appeals to. But in China, it's really China. And by the way, roughly equivalent in size, actually China is a little bit bigger. India being an interesting prize on the side. If you're talking about who wins the technology issues there. But the reality is that cohesiveness in the Chinese market allows for far more control and allows for a greater degree of ensuring that whatever standards are being designed by government entities or business entities are adhered to, and that tends to stifle a little bit of creativity. But that said China has made rapid progress. Many of their companies made rapid progress. I think the key on the technology story is actually going to end up being foundry capacity and without getting into all the details of it, it takes a long time to manufacture chips. It requires a lot of precision, a lot of clean water, a lot of other things that are at very, very extreme levels. And what's important about that is that it's very hard to build a foundry from scratch on day one and have it running on day three. It takes months, if not years, in some cases to get things up and running. The US has disinvested from all a bunch of things, including foundries making chips, and much of that capacity manufacturing is in Asia. I think the sensitivity that we should be thinking about is where does that chip manufacturing capacity end up and who's going to get to control it. I think we're going to have to be in a place in the United States where we've got to build more foundry capacity to address ultimately, what's going to be two tech ecosystems that may talk with each other, but may not share as much given that the tech ecosystems do other things besides provide commerce. They provide other surveillance opportunities as well.

Mike - So I'm going to shift gears to where you're investing your money, or client's money. Mainly, I read a lot of questions around the stock market. And I'll be a little more specific here. The S&P year over years, 29% increase. It's at a high. The S&P I think XUS global equities has outperformed those global equities by 7%. It's been an incredible return. And yet valuations just from the questions coming in, people feel a little nervous, but there's also the fear of missing out. Are you still a little bit constructive on the stock markets, namely US equities?

Chris - You know, reasonably so. There's three reasons for it. You know, they're not pound the table compelling, but taking collectively they amount to, there's still a good reason to take... there's still good reasons to take risks. Number one, there still aren't a lot of alternatives. We've used the acronym, ANGEY, alternatives not good enough yet stocks still be bonds, still be cash on any longer-term inflation adjusted basis, at least in our view at this juncture. So that's one. Two is despite starting at 2022 times earnings valuation is not your best indicator of an imminent crash. It's an indicator of where you start from may affect your long run returns, but in any one year, it can be all over the place. So I think that's important. I think the last piece of the puzzle, which is actually the most compelling is that has been an upward shift in the profit margin story in the United States that's been ongoing for the last 20 years, almost exclusively due to two things. Number one, cost cutting. And that's the whole robots for people, but to more importantly, tech deployment and the deflation that comes with that. So said another way, an iPad year over year cost X dollars. It's X minus, usually, usually, but mostly a lot of tech deflates year over year, particularly the hardware pieces. Why is that important? Because companies can continue to reinvest aggressively in technology-based solutions and continue to preserve their profit margin. So if you're at a capitalistic viewpoint and they're going to leave everything else out, the social and other issues, from a purely capitalistic viewpoint, that's actually not a bad setup. There's not a lot of alternatives. You know, we're in a place where valuations are high, but you know, it's in a place that's pretty well supported by this astounding margin story that continues to remain relatively strong, even through the pandemic. I think that's under appreciated by folks who are fearful and maybe more appreciated by folks that are willing to take some risk in the markets. That said we are faced with the big gorilla in the room, which is fed liquidity. It's just sloshed over everything, made everything a good investment, and that's not true. And it's put, I think for most investors in their minds is that's the single trigger, the only one I need to look for. Well, it turns out that if you look at the period, for example, from 2000 to 2010, when the stock market made almost nothing, there were lots of other things to do besides just buy the stock market. And that simple on, off switch stock market, yes, no. Fed. Yes, no. Well, it's easy, I think in a good heuristic that most people want to start with. It does not tell the whole story. And more importantly, for certain types of clients whose personal rate of inflation is not what the government says it is.

You got to think about how you're investing, whether it's in public or private markets in order to stay ahead of that inflation story, because that's really what I think is important when you're talking about what might the next 10 years be even if we start at high valuations, there are things to do either in public or private markets. It's not a abandon all risk because the fed is not supporting it. That's not the way forward.

Mike - So a lot of questions, maybe a little unfair, should I invest in the stock market today, but I guess I would recharacterize that. Would we expect a constructive equities, but also a little more volatility for the next 12 months?

Chris - Well, look, I think you have mid-term elections. You have the fed tapering, you have likely fed action. And if not, they're going to start signaling action next year. So once that liquidity comes out and you start to get a lot of things. There's a lot of superheated elements going on in the economy, places that have been, you know, overfunded and places where there've been some excesses. And as liquidity tied withdraws, we're likely to see some of those things pop off, a little bit like popcorn. So I'd expect that kind of popcorn event driven volatility to be a hallmark of what 2022 looks like, whether it's politically driven in front of the 2022 elections, whether it's engagements with China, you know, economically or otherwise, or if it's driven around corporate announcements. And keep in mind, we're doing this call October seven, we are just in front of the most important earning season that we could possibly be in for equity growth going into next year. We think there's three things to watch for. One, the maintenance of profit margins, because if you don't maintain them, our growth story for 2022 comes down a bit. Number two is indications that the supply chain issues aren't getting worse in some industries, they will, but broadly speaking, we want to see them start to stabilize. And I think number three, we want to see companies continue to demonstrate discipline, but also opportunity where they can grow, invest in that growth. You've seen, for example, a number of financial sector companies start to raise minimum wages. They must see growth opportunities to be able to do that. I think that's a wonderful thing. Those three things together raise our confidence. And by the way, here's why it's important. The third quarter earning season that happening in October is typically the one where analysts look to see if a company is going to make their year or not. Because if you miss in the third quarter, you can't make it a whole year. And if you miss the whole year, guess what happens to next year's forecast. Those come down too. So this is pretty crucial the next couple weeks, I think for our perspective, we expect those things, those three issues to largely play out. We think in inequities favor, it would give us an opportunity to rebalance portfolios going into what might be a tricky December if 2018 is the playbook.

Mike - So before I get into alternative investments, lots of questions on crypto. I think it's appropriate now to ask you. And I had to check the price of Bitcoin. It's $54,000. Today was $33,000. Last time we did this, and then it was $55,000. The time we did this before, talk about volatility. But then just, you know, crypto in general, I'd probably more your perspective on digital assets and blockchain. But I mean, it seems like every day there's a new crypto. The new new one is a Shiba Inu. It's now a top 20 crypto. Elon Musk tweets his a picture of his new Shiba Inu dog and the stock goes up 50%. It's up 367% in one week. What is going on here?

Chris - Well, I think you can say three things. One symptomatic of an excess of money looking for a home. Number one, number two, gamification, which I think, sorry SCC had, Mr. Gensler has talked about, which is now it's just easy, almost like a game to kind of sling money at ideas or not regardless of the fundamentals. And you know, the reality I think for most investors, at least in those things now is that they're probably younger and they have a different mindset about what the role looks like and their ability or desire to take risks with respect to things that may look interesting to them. And that they're very conversant in. So that last point, I think is one of the more important ones between gamification and who's actually doing this. It is important to understand that when you look at the thousands of cryptocurrencies out there. They are not all doing well, some are kind of dead in the water in fact, most are, but there are some that become highlights, you know, for those that study Charles Kindleberger and the history, the south sea bubble, you know, company charter says, "I don't know what I'm going to do, but just trust me, I'll do it." You know, some crypto, it looks a little bit like that. That's not because I have a FUD problem for those of you that worry about fear, uncertainty and doubt. It's much more because the underlying math and the actually way some of these cryptos work, isn't a long-term solution. Particularly if you're talking about applicable use in both commercial and non-commercial settings. What's important about this, at least at the commercial side is that there are standards of use, fungibility as well as configurability for many of the algorithms that are out there. Ethereum, for example, is one that has some of those features. So if you're thinking about investing in the long-term, you might look for those features, everything else, at least from our perspective looks highly speculative.

Mike - Chris, I got a little blue angels background noise. We have fleet week in San Francisco.

Chris - Yes.

Mike - So I apologize if that comes through.

Chris - Love it.

Mike - Did you say FUD?

Chris - We wrote a piece not too long ago. It was a little bit tongue in cheek called, "What the FUD is going on in Crypto?" And FUD stands for an acronym, fear, uncertainty, and doubt. And it's often used by very bullish folks in the crypto world to say, "Hey, you doubter, you're definitely wrong because you have a FUD problem." And I think, you know, let's call it seasoned eyes with a lot of different things going on. There are some really good cases for the way crypto prices may evolve, particularly because the scarcity of some of them. Bitcoin, is an example, it's getting scarcer and scarcer. It makes sense that some of these things are moving, but it's used as a replacement for the US dollar, that's a pipe dream that you should just throw out. That's not going to happen. So the idea here is that you have to change your way of thinking about how some of these things have evolved. They may be more collectibles. You know, microscopes on the internet, or say muscle cars? And it doesn't mean that they're not worth zero. It just means that what other people think they're worth, gold as their paintings, et cetera, the intrinsic value may not have much, but the scarcity value may drive the prices here.

Mike - Can our clients get ahold of your FUD piece through their wealth advisor?

Chris - Yes, they can.

Mike - Okay, good. So I'll just make a note of that. The other thing I would mention, I want to move into climate, not your sort of opinions on it, but more of, well, I do want to get your opinions. We're doing a Climate Summit on October 13th, October 19th, October 28th.

Chris - Three part series. Yes.

Mike - And you will be one of our guest speakers talking about various things as it relates to climate. It was interesting when I mentioned Putin coming, you know, to the energy rescue of Europe today, he's blaming some of the energy issues on the climate or our commitment to green. But just, you know, conceptually, what would we expect at the Climate Summit, but more importantly, what are some of the implications from an either economic or inflationary perspective as it relates to climate change?

Chris - Well, first thing let me just say, I find it a little funny, hypocritical and maybe ironic when US shale producers were going gangbusters and driving the price of everything down. Oh, it's those darn shale producers. Now that they've kind of shut off and you know, exhibited price discipline, they're all turning back on rig counts have not got back up to where they were. It's climate change that's kind of, it just find something else to blame. Very, very, very ironic, I think. You know, from our perspective, the climate story is one that's going to have a multitude of effects. And I think increasingly investors should not view this as, "Well, it's going to happen in 50 years. I'm fine." We know this because some of your other investors are already taking action. I think I'm going to get the number right, but I may stand to be corrected. I think it's several thousand dollars per square foot per linear foot above sea level that you have to now pay extra as a premium in Palm Beach County. Now there's liquidity and everybody wants to move there for other reasons, but that's an interesting dynamic. Same as true in parts of the Netherlands. Higher land relative to rising sea levels is much more expensive. So you can't say this isn't going on now because it is. I think you may say that's a local issue. And if you live in Chicago or you live in, you know, parts of Wyoming, that may not be necessarily true for you, totally get that, but it will have some effects. Think about what climate does to food supply. The way food supply is so productive these days is because it's all machine-driven. Robots drive combines. It's planted by GPS. But what we really depend on is weather stability. We don't depend on torrential rains in Alabama ruining cotton crops, or, you know, in the United States taking out portions of wheat. And while, those may be episodic events. The disaster of harvest down in Brazil is another example. The torrential rains in Italy, 24 inches in 24 hours, you know, hurting some of the wineries. Those may seem because they're all over the place you hope it doesn't happen to you. But the reality is if these things are happening with greater frequency and they have greater severity sooner or later they hit home. That's really the issue. And if we talk about the current state of the world, supply chain issues, you end up in a place where you can get some of that popcorn effect driven by climate issues. And it's something that will help to sustain the inflation story we're talking about over a longer period of time.

So from our perspective, this climate story has both an inflation piece to it and then for mostly countries that are, you know, on the emerging side, it's going to act like a tax 'cause they're going to have to make meaningful adjustments to their infrastructure, to respond to everything from higher temperatures to rising sea levels.

Mike - So this is a secular change. This'll be going on as long as-

Chris - We're at the beginning of it. Yep. We're at the beginning of it.

Mike - Well, thank you for what you're doing there. I encourage our clients to sign up for the Climate Summit. Again, talk to your wealth advisor, your relationship manager. Couple of questions around private equity. I guess I asked that differently. You mentioned, you know, a lot of liquidity looking for yield, and you're certainly not going to get it from a bank deposit account. You're not going to get much from a US treasury. So a lot of money chasing, chasing yield, you look at areas like private equity that dry powder is approaching $1.1 trillion. It was about $800 billion before the pandemic. So clearly a lot of money moving in that direction. What are your thoughts in general around alternative investments in that liquidity phenomenon going on right now?

Chris - So relatively constructive, pretty bullish actually. And the opportunity for clients that are qualified that understand it and are comfortable taking, you know, illiquidity risks, the return premiums. It's not just for your money being locked up, but the return premiums from operating a business more efficiently, you say maybe using more technology or for a number of other reasons are all, I think very relevant in terms of that story of why private markets are attractive. And yes, they do use debt and leverage. And we anticipate that the cost of capital, debt capital is going to remain relatively low over a longer period. That actually helps private markets to a degree, but this operational benefit as well as the others, I think is an important dynamic that you need to understand in order to take on these risks. So from our perspective, well, you can't divorce private markets from public markets, you can look for a different set of opportunities. There are very few public market opportunities to participate in, let's say tractor dealership roll-ups, but there are some interesting private market opportunities. There are very few public market opportunities to participate in the salinization of aquifers near coastal areas. But there's lots of private companies looking at pipeline and moving water, et cetera, from one place to another. So I think that opportunity set ends up being very different. And we tend to focus on that as part of the way we look at private markets where there's industry breaks, or big gaps between supply and demand and other thematic elements that we find attractive, including some that are straightforward, like where we're seeing kind of second tier airports logistics, the whole Amazonification of the way we think about distribution networks is a big change for the way logistics and real estate operate.

Mike - Couple of questions around taxes and not only how that might change your investment strategy, but more importantly, this is from Jeff, how are the tax increases, both income tax, corporate taxes, are they going to affect the market negatively?

Chris - You know, the short answer is maybe, but not as much as people think. So let's kind of put a pin in a couple of things. The first is the corporate tax rate. So at this point, even if we get to say 25 or 27%, remember the profit margin story we're talking about, companies have enough levers that can manage it to a certain degree, not completely, but a certain degree number one. What that means to us is that maybe the corporate tax rate hike only cuts 5% of EPS off from what we might have otherwise seen. And that's not a high hurdle at least in our view, that's number one. Number two is the income tax at the personal level seems to be, as the current plans are constructed to be geared towards higher net worth individuals. And it's probably more important to not worry, I hate to say this about the income tax, but about all the other taxes. Taxes on grantor-retained annuity trust changes, for example, taxes on Roth or some of the limitations on Roth IRAs. That's something where you need to engage your financial planner and think about how you structure your wealth because not getting the structure right makes it much harder to fix whatever damage happens just by generating outperformance in the markets. Think we're great, but the reality is get the structure wrong, it's a very expensive endeavor to try to fix it with only market performance. So I think our advice would be anchored on that second point, which is there are likely to be some changes. And, you know, at the end of the day, we do expect higher taxation elements between here and what we're going to see over the next 10 years. Our higher taxation picture broadly speaking. And what that should do is cause people to rethink how they're locating assets, where they're locating them and ultimately how they're structured.

Mike - Chris, a couple of questions on real estate. And I know that's a broad category and it's a local business, but maybe narrowing it down to any thoughts on residential and commercial real estate. And you, you brought up Amazonification, so that probably ties in industrial forecast on real estate investments.

Chris - You know, our real estate view is actually reasonably constructive. I think the office space, you know, it's pretty clear that it's going to be challenged for awhile, but the good news is that many office spaces can be repurposed. And that real estate in many of those areas has a lot of other uses, whether it's to grow hydroponic lettuce as Amazon is trying right now in certain areas, for example, or if it's to be a delivery center. So if you want to get two hour delivery of something, that's part of the Amazonification story. But I think more broadly, the housing demand that we're seeing now is likely to be helped on the multifamily side, as well as to a certain extent, the residential side is you're seeing certain markets just go sky high. There was a headline today, for example, our average home price in California at $800,000. So opportunity there to think about where people are living. Remember that tech migration, if you can live in Montana, you've probably seen the headlines or Wyoming or Iowa or wherever it is that your heart desires and still do your work. Then we're likely to see some of those pressures of bait, but some of the demand areas now might change. It was concentrated in the tech hubs. So here's the quick statistic we've used in the past at a period for our 10 years running through, I think 2018, 90% of the jobs in the technology space were created in only five cities. So talk about housing crisis in those cities. So Seattle, San Jose, San Francisco, San Diego, and Boston, wasn't Austin, Texas, by the way, it was Boston. So why is that important? Because those are places that saw some really big housing changes. But if you're talking about a more distributed workforce that should even out some of the pressures, some of the pressures, at least in some of those areas.

Mike - So Chris, I think we're at the end of our time here, I've exhausted my questions and our clients. Anything I didn't ask or maybe said differently, it feels like we've got quite a few tailwinds still in place for the next 12 months with a little bit of choppy waters ahead, perhaps.

Chris - Yeah, look, I think if we were to summarize everything we talked about today, I'd make a few points. So the first is that even though we're past the peak and growth and stimulus, et cetera, there's still a lot more room we think between here in 2022 for growth to develop in a constructive way. And constructive means higher than what everyone's expecting. And I think the fed and others are expecting kind of low numbers. We think it could still be in the four handle range. That's number one, number two. Yes, the fed is leaving the party or trying to leave the party, but that's telegraphed well. So that gives you ample time to think about where you structure your wealth, but also where you want to be investing. It may be a time to shift your thinking from, Hey, just by the market because the fed to, Hey, are there certain areas of the market that benefit from higher inflation, whether it's industrials or financials, for example, or as more of the COVID vaccines get deployed globally, the rest of the world should catch up. We were too early on that call earlier this year, but you could see markets outside the US actually do relatively well. I think the last piece is that we do expect to your point, Mike, a popcorn-like, or a bumpy event-driven ride cause we have midterm elections coming up. We still need some resolution with China and all of those, as long as the fundamentals, that margin stories stay in place, look like rebalancing elements rather than, Hey, I've got to just wash my hands and move on. Cause that's not where we are.

Mike - Christopher Wolfe, Chief Investment Officer of First Republic Investment Management. Chris and his team put out a lot of great research for our clients. So I want to thank our clients for joining us, but if you'd like to get access to that research, please again, contact your wealth advisor or your relationship manager, and we will certainly connect you. So Christopher, I want to thank you again. I always feel a little wiser and a little more calm each time I get a chance to talk to you. So I appreciate all you do and thank you for your time.

Chris - Thank you.

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